Wrong Policies Will Delay Any Real Recovery …

More than six years ago, Fed Chairman Ben Bernanke — then still Fed Governor — gave a laudation for Milton Friedman, one of America’s leading economists.

Friedman’s view on the Great Depression holds that the stock market bubble of the Roaring 20s was not the reason for the Depression. Instead, it was the wrong fiscal and monetary policy in the years after the bubble had burst that caused the Depression.

Bernanke publicly said to Milton Friedman:

“Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”

Bernanke assured Dr. Friedman that policy makers had learned their lessons from the Great Depression. Unfortunately his statement seems too optimistic.

I don’t agree with Friedman’s theory. I’m sticking with Ludwig von Mises and Murray Rothbard who blame the stock market bubble for the consequences of the Great Depression. What’s more, they blame the Fed for allowing bubbles to grow in the first place.

According to this school of thought, the Fed was in the process of doing the same thing again just when Bernanke made his promise to Friedman …

The easy monetary policy from 2001 to 2005 induced the biggest real estate bubble of all time to develop. As forecast by Mises and Rothbard’s theory of the business cycle, it was the bursting of the housing bubble that has done all the economic and financial damage you’ve witnessed during the past 18 months.

The Bigger the Burst Bubble … The More Devastating the Recession to Follow

If a theory or model is wrong, predictions will not come to pass. Garbage in, garbage out. That’s why Bernanke and his Fed buddies did not see this recession coming and kept underestimating its depth long after it had begun.

Remember Bernanke’s estimate of bank loan losses in 2007? He reckoned it would be “up to $100 billion.”

Now these same experts see “green shoots” everywhere! They want to assure you that the crisis has passed, that banks have become miraculously healthy again and that green pastures are just around the corner.

In my opinion, this upbeat scenario is very unlikely. I wish it were true. But theory and history argue strongly otherwise …

You see, the problems stemming from the housing bubble are not resolved yet. Following on the heels of the subprime debacle, a huge wave of Alt-A and option-ARM resets are in the pipeline. They will soon start showing up as huge credit losses.

So the next real-world stress test for the financial sector is in the offing. A glance at this credit pipeline makes clear that it will last until the end of 2012. And reality isn’t as forgiving to banks as the Fed and the Treasury are.

Financial History’s Message: It’s Not Over Yet

On January 3, 2009, Kenneth Rogoff from Harvard University and Carmen Reinhart from the University of Maryland published a study called The Aftermath of Financial Crises. The authors analyzed recessions caused by financial crises, and here’s what they found:

Real estate lost 35 percent on average, and the bear market lasted approximately six years.

Stocks tumbled an average 55 percent, and the bear market lasted three years.

Unemployment was on the rise for four years and peaked seven percentage points above the cycle’s low (3.4 percent in the U.S.).

GDP contracted by more than nine percent.

Government debt rose strongly, on average by 86 percent.

These empirical findings make it clear that the likelihood of a real turnaround is rather dim. And that there is more downside to come!

Wrong Policies Will Delay Any Real Recovery …

Bernanke assured Dr. Friedman that policy makers had learned their lessons from the Great Depression. Unfortunately his statement seems too optimistic.

As a German citizen I have always admired the deep cultural rooting of the idea of freedom in the U.S. Among all classes of U.S. society the importance of freedom, economically and otherwise, seems to be fully understood. Unfortunately, the current financial crisis is undermining freedom on various fronts.

Case in point: The proposed handling of Chrysler’s debt …

Whenever you lend money you expect to get it back. But you know that sometimes borrowers default. This event rarely means a total loss, since a bankrupt company usually has some assets. Laws and credit contracts make clear who gets what and whose contracts come first.

These rules are paramount to the functioning of the capital markets. Without them, lending as we know it would probably not exist. But now, in the case of the Chrysler bankruptcy, these rules are being questioned by government officials.

Instead of sticking to the contracts, politicians are trying to change the rules of lending during the game. If they get their way, this will be a huge blow to the financial markets — not just in the U.S. but in Europe as well.

Politicians are changing the rules of capitalism. A perfect example is the deal they’re concocting for Chrysler.

After all, when the U.S. doesn’t stick to the rules of capitalism, how could European policy makers be expected to have the guts to do so?

So this development in the U.S. is very sad and frightening for the rather small minority of European capitalists.

And it is very frightening for the future of the capital markets, too. All the efforts to get the broken lending machine running again will be dealt a huge blow. This is not a minor development. It targets the core of the financial markets. Indeed, it has the potential do a lot of long-term harm to lending, the financial markets, and the economy.

There are many unresolved problems we have to deal with. This recession is not over yet. If politicians set the wrong course for the economy in this very fragile environment, I see a real danger of a repeat of the Great Depression.

The situation is bad. And more government policy can make it much worse, which is what happened in the 1930s.

Let’s hope they won’t do it all over again!

You can see why I continue to suggest using the current bear market rally to sell stocks and mutual funds. Think of it this way … if somebody had offered you a 40 percent premium on your stock holdings 10 short weeks ago, you would have probably taken it, right? So why not take it now? Have things really changed all that much? I don’t think so.

Money and Markets (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Tony Sagami, Nilus Mattive, Sean Brodrick, Larry Edelson, Michael Larson and Bryan Rich. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive. Regular contributors and staff include Kristen Adams, Andrea Baumwald, John Burke, Amber Dakar, Dinesh Kalera, Red Morgan, Maryellen Murphy, Jennifer Newman-Amos, Adam Shafer, Julie Trudeau, Jill Umiker, Leslie Underwood and Michelle Zausnig.

Attention editors and publishers!Money and Markets issues can be republished. Republished issues MUST include attribution of the author(s) and the following short paragraph:

This investment news is brought to you by Money and Markets. Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.moneyandmarkets.com.

From time to time, Money and Markets may have information from select third-party advertisers known as “external sponsorships.” We cannot guarantee the accuracy of these ads. In addition, these ads do not necessarily express the viewpoints of Money and Markets or its editors. For more information, see our terms and conditions.